WEALTH HEALTH: Forget ‘alternative’ funds; active funds are better

Investors have heard a lot in recent years about how active management doesn’t work, but how alternative investment strategies do.

While experts offer various measures as proof of those concepts, fund performance isn’t quite so clear.

Yes, it shows that most active fund managers have a tough time beating the market and/or a relevant benchmark, but it also always highlights how a few managers break the mold.

Moreover, it shows how mold is often what’s growing in alternative funds, where entire asset classes that sound good in concept have been ineffective in practice, burdened by above-average costs and trading structures that make superior results unlikely.

Knowing that so many investors have embraced indexing, David Goerz of Strategic Frontier Management in Danville, Calif., has come up with an unusual suggestion for investors looking to balance or juice up their portfolios: Make active management your “alternative” investment.

“Alternative investing has been so disappointing to investors, and yet they continue to discuss and talk about it,” said Goerz. “All the money that had flown into alternatives is now stalling and re-evaluating what is going on … looking towards traditional, solid active management makes sense.”

To see why what Goerz is suggesting is a radical shift, you need to consider the purpose of “alternative investments,” which historically meant investments into asset classes besides stocks, bonds and cash.

Investors turned to alternatives – classically investments like real estate, gold and precious metals and more – to diversify a portfolio, making sure they had assets that were not affected by the whims of the stock and bond markets.

With the evolution of exchange-traded funds, however, alternative strategies morphed from simply buying different asset classes to taking on hedge-fund strategies, buying specialties like managed futures and more. They also use management styles beyond the normal growth and value mainstream.

Throw in the evolution of “smart-beta” funds, which typically alter an indexing strategy in an attempt to improve results by delivering bigger profits, minimizing volatility and/or lowering risk.

The problem, however, has been that many of the hedge-fund like strategies have proven ineffectual, particularly in markets that have been rising for years now seemingly with no interruption. The same rising tide that has made it hard for a traditional active manager to beat the index has had alt funds drowning.

Over the last five years, most of the alternative fund categories tracked by Lipper Inc. badly lag the double-digit gains produced by the average large-, mid- and small-cap fund – regardless of management style. The average alternative global macro fund, for example, is up less than 2.25 percent over the last five years; alternative event-driven funds are up, on average, 3.5 percent in that time, according to Lipper.

By comparison, the average Standard & Poor’s 500 Index fund is up 13.4 percent in the last five years, with all of the large-cap categories for active management showing gains north of 12 percent.

Active and passive strategies have always co-existed in portfolios, but as more investors have gone with indexing as their core strategy, traditional active funds have been squeezed out.

When investors have decided to add an active component to an indexed portfolio, it has been through alt funds.

Goerz believes investors would be better off by diversifying through adding active management, especially with so many alt funds being more about their strategy than about buying truly unique assets.

“We think that active management might be thought of as a new alternative with very low correlation relative to other markets, it can add diversification if you use a manager who is unique and different,” Goerz said. “Alternatives really haven’t been working but active management is, in itself, a source of return that in a low-interest rate, low-return environment could add [0.5 to 1.0 percent] in value, net of expenses. Over time, that truly adds up to a lot of wealth accumulation.”

Of course, finding great managers has never been easy; it’s precisely why indexing has carried the day and earned the conventional acclaim as the best way to invest.

But no less an expert than Seth Klarman of the Baupost Group has said that the more people believe in indexing and efficient market theory, the more inefficient the market becomes. That creates opportunities for active managers to capitalize and outperform.

Steve Graziano, president of Touchstone Investments, notes that investors are looking for funds with a lot of “active share,” a measure that shows the percentage of a manager’s portfolio that differs from the benchmark index.

“For someone who is an index investor, yes, adding active managers with high active share would achieve the same things most people are looking for when they buy alternative funds,” Graziano said. “People like the idea of alternatives, but fundamentals stand the test of time; most investors would be happier, I think, using a good active fund than using an alternative to diversify.”

Chuck Jaffe of Cohasset is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com.

Chuck Jaffe of Cohasset is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com.

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